Cost of Goods Deductibility

Deduction for cost of goods sold limited to negotiated discount price IRS concluded in this ILM that the step transaction doctrine applied to the repayment to companies of the difference between the full list price of merchandise and the negotiated discount price, and therefore the companies’ deduction for cost of goods sold (COGS) was limited to the negotiated price.

Facts. U.S. companies paid the full list price for merchandise and were reimbursed for the difference between the full list price and the negotiated discount price.

IRS analysis. The Service concluded that this transaction met all three tests applied by the courts in determining whether the step transaction doctrine should be invoked:

(1) The end-result test. (2) The mutual interdependence test. (3) The binding commitment test.

Under the end-result test, separate transactions will be combined into a single transaction when it appears that each step was a part of a single transaction. The Service determined that this transaction satisfied the end-result test because the payment by the companies of the full list price was a component part of a single transaction that included the repayment of the difference between the full list price and the negotiated discount price. The Service noted that all of the parties involved knew the price of each item on the day the order was placed, and the ordering system was put in place to induce the companies to place more centralized orders. Because the companies understood that their actual COGS would be the negotiated discount price, not the list price, the end-result test was satisfied.

The mutual interdependence test concentrates on the relationship between the steps (i.e., the steps so interdependent that the legal relations created by one step would have been fruitless without a completion of the series). The IRS concluded that the companies would not have paid full list price for the merchandise without knowing that they would be repaid and the true price would be the negotiated discount price. Therefore, the transaction satisfied the mutual interdependence test.

The third test requires that there be a binding commitment to take the later steps. The Service determined that the application of the step transaction doctrine was warranted because the companies were provided with price lists that they relied on when ordering and if they didn’t receive the repayments as promised, they would have had legal standing to compel payment.

Because the step transaction doctrine applied, the companies could not deduct as COGS the full list price of the merchandise ordered, but were limited to the negotiated discount price.

Implications. The payment by the companies of full list price, followed by the receipt by the companies of a rebate (so as to reflect that the true cost to the companies of the merchandise was the negotiated price), apparently represented transactions that were closed rather than transactions that were still open. Had the right to the rebate, or the amount thereof, been in some way unknown or contingent, which was not the case here, the companies likely would have reported income from the rebate, reflecting that the companies understated income previously by overstating COGS. It is clear, based on the application of any of the tests under the step transaction doctrine, that both the right to, and the amount of, the rebate owed to the companies was established with certainty.

While the facts do not indicate why the inter-company transaction provisions of the consolidated return Regulations were implicated, the memorandum provides a useful, although brief, description of the three alternative tests under the step transaction doctrine and reminds taxpayers that satisfaction of any one of the three tests is sufficient for the step transaction doctrine to apply.

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